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Chapter 7. Option Strategies in Down Mar... > Option Planning with Loss Carryover

Option Planning with Loss Carryover

One potentially troubling aspect of using options in down markets is the possible tax effect. If you create capital gains through exercise, those gains are taxable. Do you prefer reversing paper profits or deferring taxable gains? A lot of emphasis is placed on tax deferral, but in reality, you are better off accepting additional tax this year if that tax results from creating net profits.

The alternative—holding on to shares of stock whose basis is higher than current market value—affects your current investment return and, in some cases, traps you in a losing portfolio position. If you can use options to change the course of profits, you are far better off. For example, let's assume that your effective tax rate (federal and state combined) is 40 percent. All additional income you generate will be taxed at the 40-percent rate, and your after-tax profit will be the remaining 60 percent. In this condition, are you better off waiting?


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